May 17, 2019
Most of us are familiar with the stock market. But have you ever wondered what the institutions and high net worth individuals are investing in? Alternatives.
We’re here to break the news to everyday investors—stocks and bonds are not the only investment vehicles out there! From art to coins, farmland to venture capital, natural gas to real estate, alternative investments are becoming more accessible and continue to be a sought after addition to one’s portfolio.
So what are alternative investments, why are they important, what are the advantages and drawbacks, and how can you get started? This article will discuss all of that, as well as take a deep dive into 5 of the most common alts that individuals can invest in–and not just the wealthy.
Simply put, alternative investments are an asset class that doesn’t fall into conventional investment categories such as stocks, bonds, or cash. Alternatives, commonly called “Alts,” are outside of the stock market and they are available for institutions as well as individual retail investors to access.
As mentioned, alts are the investments that don’t fall in line with equities, fixed income, or cash equivalents. They can include:
The list of alternatives could go on and on. We’ll discuss 5 of the more common options in more detail below.
One of the best-known tangibles and alternative investments is real estate. If you own a home or rent a home, you are familiar with it! Investing in real estate can be as simple as owning a property for purposes other than personal use. Real estate comes in many forms and there are many ways to invest in it. There are different property types such as residential, retail, commercial, and industrial real estate. Real assets like real estate can be accessed directly (fix and flips, rental yields, or commercial assets) or indirectly through a Real Estate Investment Trust, also known as a REIT.
Private equity can be defined as an investment in a private and unlisted company. If you think about it, there are a lot more private than public companies, and many need investor capital in order to grow. Institutional investors or high net worth individuals can place their money directly in these companies, or one can invest through a private equity firm. Private equity firms will raise investor capital and invest on their behalf in private companies that show great promise and potential. If the company gets acquired or becomes public, investors receive their return. Private equity can encompass investing in start-ups and venture capital as well.
Venture capital (VC) invests in companies that have great growth potential and that, hopefully, the investor truly believes in. This sounds similar to private equity, but venture capital focuses on startups. VC investments have a long investment horizon, upwards of 5 years. They are also high risk, high reward in nature due to the fact that many startups fail. However, if the startup turns into a success, VC investors can enjoy returns up to 10x their initial investment amount!
Hedge funds are pooled investment funds that invest in a variety of different assets using different strategies. They are designed to generate consistent returns and preserve capital. Hedge funds tend to invest in riskier assets and derivatives. Because hedge funds invest in public equities, they are typically a liquid investment. Regular hedge funds have a high barrier to entry, as they require investors to be accredited. However, everyday investors can invest in funds of hedge funds. Funds of funds are an alternative to investing in individual funds directly. This offers diversification and a way to invest in hedge funds for a lower minimum.
Commodities refer to natural resources. There are so many of them that they fall into three categories- agriculture, metal, and energy. When you think commodities, think items like beef, cotton, sugar, corn, natural gas, coffee, copper, silver, etc. The purchase and sale of commodities are typically executed through futures contracts. Everyday investors can gain exposure to commodities through different vehicles such as commodity futures, ETFs, or shares in mining companies.
Standard tangible investments can include real estate, gold, art, antiques, coins, collectible cars, etc. Investors are drawn to these investments because of their physical form and natural value. It’s a different investment than the “paper assets” you own in the stock market. Tangibles are unique in the fact that they provide utility (a home), satisfaction (a car you collect) and the potential for appreciation (the sale of the tangible item).
Alternatives are an important component of a well-balanced portfolio. They offer the potential for high returns as well as protection from the volatility of the stock market. Below are some of the top reasons why adding alts to your portfolio can pay off.
At the end of the day, everyone would like to see higher returns in their portfolio. However, with higher returns, can come higher risk. Alts can be very lucrative and offer returns significantly higher than stocks or bonds. Hedge funds aim for about 25-30%, while REITs have shown average 20-year returns of 11.8%- both significantly outperforming the S&P 500 Index’s 20-year average returns of 8.6%.
We live in an era of choices, and alternatives give you just that. People enjoy the idea of investing in something other than the cookie cutter stock and bond market. There is also the allure of investing in an industry that you are interested in, such as coins, wine, real estate, or cars. No more playing by old-school rules or being limited to few options.
Investing in hard assets such as gold, property, or oil provide a hedge against inflation. These investments provide protection against the decreased purchasing power of the dollar. When prices go up (inflation), these assets are expected to keep their value or even increase their value, therefore protecting your money.
One of the most notable advantages of alts is the protection they provide against the stock market’s volatility. In today’s landscape of frequent volatility, trade war talk, and recession talk, alternatives continue to be a sought after choice. Alternative assets typically perform with low correlation to stocks and bonds. This means if your stocks are down, your alternatives are likely to remain steady.
Last but not least, alternative investments provide diversification. Diversification mitigates the volatility mentioned above. Due to their lower correlation to the stock market, alts, can help cushion loss when other parts of your portfolio may be underperforming.
Investing in alts, like any other investment, has advantages and drawbacks. It is important to identify whether or not one of these non-traditional options works with your risk tolerance, investment timeline, and overall objective.
As mentioned, alternative investments can provide protection, diversification, and higher-than-average returns to investors. Another advantage is that they oftentimes have unique legal and tax considerations that can be highly leveraged.
In addition to potential tax benefits, alts allow individuals access to investments that were once off-limits. Most alternatives were once exclusive to the wealthy and the institutions, now these new and sophisticated investment vehicles are being accessed by retail investors.
The drawbacks of investing in alternatives may include the potential for higher risk and loss, lack of transparency and regulation in some cases, access, accreditation requirements, and illiquidity. Not all alts are illiquid, however, many are more in line with a long-term investment strategy. It is important to remember that with the right research and partnering with an SEC-regulated sponsor, many of these drawbacks can be overcome.
The first step in adding alts to your portfolio is to identify which opportunity interests you the most and works with your current financial situation, risk tolerance, and timeline.
Accessing alternative investments will vary with each opportunity. In order to reap all the benefits of alts, one must typically possess some sort of knowledge or expertise in the area they are investing in and have a clear assessment of all the variables at play. Without proper knowledge of the specific markets or trends, embarking on alternatives can lead to higher risk.
Some of the above-mentioned alternatives can be accessed on your own. Some people prefer to access these investments through a wealth management firm specializing in the area. Individuals can also access alternatives through funds specializing in the asset. For example, DiversyFund allows individuals to invest in their Growth REIT, a portfolio of commercial real estate assets. Funds like this allow investors looking for alts to skip the hassle of being an expert in the field.
Another consideration when investing is deciding where you will get the capital to start. Oftentimes, individuals can use their retirement accounts such as an IRA or 401(k) to invest in alternatives.
Because of their potential for high returns, diversification, and mitigation from current market volatility, it’s a safe bet for investors to allocate a portion of their portfolios to alternatives.
With the continued demand for more of these investment opportunities, it’s no doubt that we will continue to see companies bringing alternative investments to the everyday investor.